The competition among non-Chinese junior mining companies to
successfully mine rare earth elements (REEs) began as a footrace
and evolved into a full-on stampede. That race is now unraveling,
thanks to slower global economic growth and the sheer number of
exploration companies involved in rare earth exploration. We have
seen estimates of over 300 companies involved in this global
search, and when you factor in the relatively tiny size of the
rare earth market (approximately 130,000 tons produced in 2010,
according to the U.S. Geological Survey) we still stand by what
we've said all alongthere is room here for a few major players
and not much else. We believe the rare earth industry is in the
beginning stages of a phase we call "The Great Reset." We base
this theory on four ideas:

Everything reverts to the mean. This includes rare earth
oxide (REO) prices. While we believe we will see a permanently
higher price for select REOs, this is not the case for the entire
suite of oxides, and prices cannot continue rising indefinitely.
The laws of supply and demand have proven this.

Demand projections for REOs are being re-evaluated downward
due to anemic global economic growth prospects. With a tremendous
debt overhang in the United States and Europe and evidence of
growth slowing in China (the three biggest economies in the
world), lower aggregate demand for finished goods that use REOs
is a given. We have seen forecasts for REO demand in 2015 that
are higher than they are today, and don't disagree, but the
downward revision is indicative of lower demand for most REOs.

Companies such as Toyota and General Motors are actively researching
substitutes for REOs in their products. This type of
research has been in progress for some time and we think that
these companies would not be spending the R&D dollars if
they didn't want to avoid high REO prices.

Demand projections for "green" or "clean tech" applications
such as hybrid electric vehicles, wind turbines and solar cells
are not factoring in whether or not manufacturers of these goods
can ensure a steady supply of raw materials (specifically REOs)
to meet their production forecasts. The rare earth industry is a
customer-driven business in that the customer needs REOs of a
highly specific type and purity. If a wind turbine manufacturer
can't procure a specific purity of neodymium oxide, for example,
the wind turbine may get built without neodymium, implying demand
destruction. We have seen estimates of the use of up to one ton
of neodymium needed to produce one megawatt of generating
capacity from a wind turbine. China alone has plans to install
100 gigawatts of generating capacity from wind (up from 12
gigawatts in 2009). When you factor in European and American
projections for wind power (not to mention other parts of the
world), this begs the question of whether or not there is enough
neodymium to go around and if there currently is not, will there
be enough to satisfy these growth targets in wind generating
capacity? We are well aware of the benefits of
neodymium-iron-boron magnets in miniaturization and efficiency,
but think that if a product can be manufactured economically
without REOs, then the manufacturer will choose that path or
abstain from building the product at all.

To be clearwe have not "thrown in the towel" on REOs and the
important role they play in certain sectors of the economy. What
we are saying is that the role will be different from what many
in the sector currently suggest. Like many other facets of life,
the rare earth sector is Darwinian in nature and will evolve to
equilibrate supply and demand. The gratification that comes along
with healthy and growing demand for a product (in this case REOs)
will be delayed, to the chagrin of investors and rare earth
mining company CEOs alike. This "reset" shapes how we think about
the rare earth space now and in the future and in deciding how
and where to invest. Below is a price chart of the Bloomberg Rare
Earth Mineral Resources Index and its one-year performance.

The One Sector Where Supply and Demand Don't
Matter

There is one area of the economy, however, which we think is
immune to the vagaries of supply and demand of REOs: the
military. While the potential for substitution exists with
consumer products, we believe there is no such "wiggle room" when
analyzing a country's defense capabilities. The
neodymium-iron-boron magnets we mentioned above are critical in
actuators of precision-guided bombs and are designed specifically
around these magnets. Actuators are
responsible for control of the bomb, and this is just one of
several products (lasers and radar being two significant other
products) that must use rare earths to function optimally.
Without the magnets in the bombs, performance is reducedimplying
an inferior productsomething nobody should be willing to accept.
The U.S. Military is responsible for a small overall percentage
of REO demand in the United States, but it is significant
nonetheless.

The Rare Earth Supply Chain: The Key to It
All

So at this point, we believe two things: first, demand for most
REOs will decrease in the near term, and second, that it will be
exceedingly difficult for the majority of the junior mining
companies involved in rare earth exploration to achieve
commercial production of REOs. Despite this, the singular crucial
issue that put the rare earth story on the front page of every
newspaper around the world in the first place still haunts
usWestern dependence on a critical resource from a strategic
adversary. While a seemingly endless amount has been written
about China's control of the supply of REEs, what we think is
most important (and most often missed by the pundits) is the fact
that China also effectively owns the entire mine-to-magnet supply
chain. This is the crucial vulnerability. The mining of rare
earths is the easy part. It is the resulting steps where
intellectual property is created that really matter. In 2010, the
United States Government Accountability Office (GAO) was
commissioned to deliver a report on the use of rare earth
elements in the Department of Defense supply chain. Regarding
military capabilities, the report states (Ed. Note: bold text is
ours),

"For example, the M1A2 Abrams tank has a reference and
navigation system that uses samarium cobalt (SmCo) permanent
magnets. The samarium metal used in these magnets comes
from China."

Whether we're discussing heavy rare earth elements (HREEs) or
light rare earth elements (LREEs), a particular concern is the
fact that the West is realistically years away from having a
supply chain built that can diminish foreign dependence on REOs.
Viewed that way, reduced demand for certain REOs could be a
blessing in disguise in that it can give Western policymakers
more time to formulate a viable strategy, though based on recent
behavior in Washington DC (i.e., the debt ceiling debate), we're
not holding our breath. The chart below shows the supply chain
for rare earth permanent magnets used in wind turbines and hybrid
vehicle motors, among other products. China is responsible for
the entire upstream portion of this chain and has designs through
mercantilist export policies on owning the entirety of the
downstream portion of the chain as well.

There are myriad issues surrounding China's trade policies and
her seeming inability to "play fair" on the world stage. The
World Trade Organization recently found that China was in
violation of international trade rules for curbing exports of rare
earths. The Chinese government is likely to appeal this
ruling, effectively kicking the can down the road and prolonging
export curbs of rare earths from China indefinitely. Though one
could, based on this factor, infer higher prices for REOs, we
still believe that slower economic growth and potential for
substitution point to lower REO prices going forward.

To get a sense of how Chinese export quotas of REOs have
decreased in recent years and the resulting increases in prices
of REOs, see the charts below:

Here are the YTD percentage increases in prices of select REOs.
More than anything else, we believe, this makes the case for our
thoughts on mean reversion and demand destruction described
above:

What to Focus on in the Rare Earth Space Going
Forward

There are numerous important factors to consider when undertaking
due diligence of a mining opportunity (management capability,
grade, tonnage, etc.) that we use in the Discovery Investing
Ten-Point Factor Model, but we think that there are three keys
one must consider initially before looking further at a given
rare earth exploration company as an investment.

Despite the fact that we believe the "easy money" has already
been made in this sector, we do believe that opportunities for
profit exist. Much has been made in recent months of "critical"
or "strategic" metals and what constitutes a metal joining this
group. We would certainly include rare earths here and, in fact,
take this one step further. We consider rare earths to be
"political metals." In the rare earth sector, geopolitics trumps
all, and this is the first factor to consider when investing in
the junior mining rare earth sector. It should be clear that we
have our doubts about permanently increasing demand for REOs.
However, due to the significant enhancements REOs provide in
military applications, access to a reliable supply of these
metals is now on the radar (pardon the pun) of politicians from
Brussels, to Ottawa, to Beijing, to Washington DC. In the United
States, Sen. Lisa Murkowski (R-Alaska) has been an ardent
supporter of rebuilding the U.S. industrial base and supply chain
for critical minerals, including rare earths. Rare earth deposits
are of strategic significance. A deposit in a safe and stable
political jurisdiction is an absolute must.

Second, when comparing rare earth deposits, a decidedly large
slant towards HREE mineralization is also a must. After all, the
HREEs are truly "rare," and forecast to be in deficit going
forward. In our opinion, investing in a large LREE deposit that
promises tens of thousands of tons of REO production per year,
when the Chinese dominate this portion of the market and are set
to do so going forward, is not a wise move. In the price chart we
printed above, dysprosium oxide and terbium oxide (two of the
most sought-after HREOs) have increased in price by 704% and 439%
respectively, year-to-date. We do not expect continued
triple-digit gains in these REO prices, but do believe that
deposits with a high percentage of HREEs have potential to
outperform going forward.

Finally, while the geopolitics and HREE content are important,
without a solid understanding of the metallurgy of a deposit, you
could quite literally be investing in moose pasture. This is one
of the ultimate differences between rare earths and other metals.
Separating 17 metals from each other is an enormously difficult
task both technically and financially. This is also a competitive
advantage the Chinese have over the Westthey have "cracked" the
metallurgy of their primary rare earth deposits. While we don't
expect miracles, we do want to see Western rare earth companies
making steady progress into understanding the mysteries of the
metallurgy. This is one of the biggest risk factors when
analyzing a rare earth exploration company.

The Future Is Never Certain, but There Will Always Be a
Place for REOs

It appears to be a rather hazy future for the rare earth sector
as slow economic growth, potential for substitution,
manufacturers potentially misreading demand for their own
products that use REOs and price mean reversion all come together
to take some of the "froth" out of this market. We think this is
a good thing. Regardless, the big picture issues surrounding the
need for REOs in various military and clean tech applications are
going to keep the industry front and center, but it will evolve
much differently than many expect. The Great Reset will ensure
that.

Chris Berry, with a lifelong
interest in geopolitics and the financial issues that emerge from
these relationships, founded House Mountain Partners in 2010. The
firm focuses on the evolving geopolitical relationship between
emerging and developed economies, the commodity space and junior
mining and resource stocks positioned to benefit from this
phenomenon. Chris holds an MBA in finance with an international
focus from Fordham University, and a BA in international studies
from The Virginia Military Institute.

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